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Thursday, July 31, 2008

One of the great stories from 20th century U.S. economic history is the great economic rebound of the American South. From the close of the Civil War up through World War II, this region’s economy had been relatively undeveloped and isolated from the rest of the country. This eighty-year period of economic backwardness in the South stood in stark contrast to the economic gains elsewhere in the country that made the United States the leading industrial power of the world by the early 20th century. Something radically changed, though, in the 1930s and 1940s that broke the South free from its poverty trap. From this period on, the South began modernizing and by 1980 it had converged with the rest of the U.S. economy. But why the sudden break in the 1930-1940 period? A new paper by Fred Bateman, Jaime Ros, and Jason E. Taylor provides a fascinating answer: the economic rebound of American South was the result of a 'Big Push' from large public capital investments during the Great Depression and World War II.

A novel contribution of this paper is that it appears to provide a real-world example of the 'Big Push' theory. Never heard of the 'Big Push' theory? Well, here is how the authors describe it:

According to the “big push” theory of economic development, publicly coordinated investment can break the underdevelopment trap by helping economies overcome deficiencies in private incentives that prevent firms from adopting modern production techniques and achieving scale economies. These scale economies, in turn, create demand spillovers, increase market size, and theoretically generate a self-sustaining growth path that allows the economy to move to a Pareto preferred Nash equilibrium where it is a mutual best response for economic actors to choose large-scale industrialization over agriculture and small-scale production. The big push literature, originated by Rosenstein-Rodan [1943, 1961], was initially motivated by the postwar reconstruction of Eastern Europe. The theory subsequently appeared to have had limited empirical application... [S]cholars have found few real-world examples of such an infusion of investment helping to “push” an economy to high-level industrialization equilibrium.

We argue here that the “Great Rebound” of the American South, which followed large public capital investments during the Great Depression and World War II, is one such application. Although 1930s New Deal programs are typically presented in the context of their attempt to bring relief and recovery to the U.S. economy through demand-stimulating public expenditures, the long-term economic effects of these and subsequent wartime expenditures were profound for the South. Specifically, and consistent with big push theoretical literature, the infusion of public capital—roads, schools, waterworks, power plants, dams, airfields, and hospitals, among other infrastructural improvements—fundamentally reshaped the Southern economy, expanded markets, generated significant external economies, increased rates of return to large scale manufacturing, and encouraged a subsequent investment stream. These improvements helped create the conditions that allowed the region to break free from its low-income, low-productivity trap and embark on its rapid postwar industrialization.

This paper deals with the break from the South's poverty trap. The sustained nature of the South's postwar economic recovery has been covered by other studies: Connolly (2004) looks to improved human capital formation, Cobb (1982) points to industrial policy, Beasley, Persson, and Sturm (2005) finger increased political competition, and Glaeser and Tobio (2008) discuss the merits of the climate or Sunbelt effect. (I will also note I have seen somewhere the advent of air conditioning did wonders for development in the South).

In short, this paper tells an interesting and under reported story of 20th century U.S. economic history. In so doing, it also provides what appears to be a good example of the 'Big Push'. Read the rest of the paper here.

Wednesday, July 30, 2008

Rich Karlgaard clues us in to the secrets of survival for firms producing consumer goods in a stagflationary environment:

At a campground breakfast last month I grabbed a little box of Raisin Bran cereal. I opened the box and popped the waxed paper, which let out a mighty whoosh of air I felt in the eyeballs. I tore the wax paper and discovered the source of the whoosh: The box was mostly filled with air. I imagined some bran flakes hiding in the bottom. To test this theory, I poured the contents into a bowl. Indeed, there was some Raisin Bran in there--about 20 flakes. I fetched two more boxes and emptied the flakes and raisins into the bowl. It took three boxes to make a halfway decent bowl of cereal.

[...]

Robbery at the cereal box indicates that stagflation is America's real problem now. Cereal vendors are afraid to raise prices. They know that American wages have risen little of late, and the small gains have been eroded by gas prices. So cereal vendors play a game with consumers: charge more by giving less.

One can't be angry at the cereal vendors, by the way. Their costs for goods and distribution have skyrocketed. They have no choice but to raise prices or serve up fewer flakes. Or go out of business...

Steve Forbes has pointed out that while the pastries he buys each morning at Starbucks cost the same, they've shrunk in size. Containers of Shedd's Spread Country Crock used to consist of 48 ounces of margarine, but buyers now pay the same price to get 45 ounces. Frequent RealClearMarkets contributor Doug Johnson notes that the cost of a package of diapers for his children hasn't gone up, but today there are four less diapers in each package.

Mark Gertler recently asserted the United States should "not act rashly over inflation" fears. He argued that the recent jump in U.S. inflation is the result of relative price changes in food, energy, and other commodities and not the consequence of policy-induced aggregate demand pressures. Mark Thoma concurs and notes that since relative price changes provide "important signals to the economy about where resources are needed most and about the opportunity costs of employing them...we don't want to mute those signals..." In short, negative supply shocks are the source of the recent inflationary pressures and are not the type of price shocks that should be addressed by policy (unless they add momentum to a growing inflationary spiral--something the two Marks do not see happening).

This interpretation, however, begs the question of why these commodity are soaring in the first place? Could it be that in addition to the usual suspects--increased Asian demand, biofuel distortions, speculators--that loose U.S. monetary policy is playing a part? Given the monetary hegemon role played by the Federal Reserve--its monetary policy gets exported to all those countries pegged to the dollar--it seems reasonable to conclude that some of the increase in commodity prices are more than relative price changes; they are in part the result of policy-induced aggregated demand pressures. That is what I was thinking, anyhow, when reading Gertler's article. I was not alone in my thinking. Ken Rogoff makes a similar case in the FT:

As the global economic crisis hits its one year anniversary, it is time to re-examine not just the strategies for dealing with it, but also the diagnosis underlying those strategies. Is it not now clear that the main macroeconomic challenges facing the world today are an excess demand for commodities and an excess supply of financial services? If so, then it is time to stop pump-priming aggregate demand while blocking consolidation and restructuring of the financial system.

[...]

In the light of the experience of the 1970s, it is surprising how many leading policymakers and economic pundits believe that policy should aim to keep pushing demand up. In the US, the growth imperative has rationalised aggressive tax rebates, steep interest rate cuts and an ever-widening bail-out net for financial institutions. The Chinese leadership, after having briefly flirted with prioritising inflation (expressed mainly through a temporary acceleration in renminbi appreciation), has resumed putting growth as the clear number one priority. Most other emerging markets have followed a broadly similar approach.

Dollar bloc countries have slavishly mimicked expansionary US monetary policy, even in regions such as the Middle East, where rapid growth is putting huge upward pressure on inflation. Of the major regions, only Europe, led by the European Central Bank, has resisted joining the stimulus party so far. But even the ECB is coming under increasing domestic and international political pressure as Europe’s growth decelerates.

Individual countries may see some short-term growth benefit to US-style macroeconomic stimulus, albeit at the expense of loosening inflation expectations and possibly paying a steep price to re-anchor them later on. But if all regions try expanding demand, even the short-term benefit will be minimal. Commodity constraints will limit the real output response globally, and most of the excess demand will spill over into higher inflation.

Rogoff goes on to address Gertler's claim that the Fed should more concerned about the financial crisis than the inflationary pressures:

What of the ever deepening financial crisis as a rationale for expansionary global macroeconomic policy? It is hard to see the argument in emerging markets where inflation is raging, but even in epicentre countries it is becoming increasingly dubious. Inflation stabilisation cannot be indefinitely compromised to support bail-out activities. However convenient it may be to have several years of elevated inflation to help bail out homeowners and financial institutions, the gain has to be weighed against the long-run cost of re-anchoring inflation expectations later on.

Another consequence of this pump-priming aggregate demand was recently mentioned by Brad Sester:

The [U.S.] policy response to the subprime crisis has avoided the sharp adjustment that many feared. But it also meant that many of the underlying imbalances haven’t really corrected. The composition of the US current account deficit has changed – the oil deficit is bigger, the non-oil deficit is smaller; the fiscal deficit is bigger and aggregate deficit of households is smaller - but the aggregate deficit remains large. And the rest of the world’s imbalances haven’t corrected either. China’s economy remains unbalanced. The oil surplus has gotten bigger.

Hence it is possible to argue — see Yves Smith — that risks are still increasing.

So in addition to potentially unanchoring inflationary expectations, U.S. policy--with help from foreign governments--has put off for another day the inevitable correction of economic imbalances.

Tuesday, July 29, 2008

Brad Sester had an interesting post that looks at how U.S. economic imbalances have been affected by the subprime crisis. First, he notes what typically happens to countries running huge current account deficits like the United States when hit with a economic crisis like the subprime one:

Emerging market financial crises in the 1990s followed a fairly consistent pattern.

The country lost access to external financing.

The sector of the economy that had a large need for financing – firms in Asia, the government elsewhere – had to dramatically reduce its need for financing. Asian investment collapsed. Argentina swung from a fiscal deficit to a fiscal surplus (helped along by its default on its external debt). Turkey began to run large primary surpluses.

Financial balance sheets shrank; credit dried up.

The country’s currency fell sharply. And its current account swung into balance, if not a surplus.

That process was incredibly painful. Falls in GDP of 5% or more were not unknown. It also meant that after a year or so, most emerging markets had reached bottom. Their economies had adjusted, as had their currencies.

He then examines the U.S. experience since the subprime crisis erupted. Has it followed the typical currency crisis pattern?

A year – almost – after its crisis, the US economy hasn’t endured a similar period of adjustment. Economic activity has slumped, but not fallen off a cliff. US households are pinched (and unhappy), but spending hasn’t collapsed. The US current account deficit has fallen, but not by much – the rise in the oil deficit has offset the fall in the non-oil deficit. Banks have depleted their capital, but I don’t think that they have – in aggregate – shrank their balance sheets...

So no, the United States has not followed the pattern. And no matter how bad you think the U.S. economy has been hit, it could be far worse had external financing dried up.

Brad's point that the typical currency crisis pattern has not held up with the United States reminded me of something I heard about the Early Warning Systems (EWS) that were so popular a few yeas back. Before I mention what it was, let me review the purpose of the EWS by way of the IMF:

The IMF uses econometric models known as early warning system (EWS) models in its efforts to predict currency crises—defined as a sharp currency depreciation or loss of foreign exchange reserves or both—before they occur. These EWS models focus on external volatility and exploit systematic relationships apparent in historical data between variables associated with the buildup to crises and the actual incidence of crises. The variables include the ratio of short-term debt to foreign exchange reserves, the extent of real exchange rate appreciation relative to trend, and the external current account deficit. Both theory and evidence suggest that the higher the value of each of these variables, the greater the probability of a crisis. Extensive tests have been performed to determine which of these empirically based models best fits the data and is the most robust.

The IMF's EWS models focus on a relatively long prediction horizon of 12-24 months to provide countries with enough lead time to adopt corrective policies. The focus is, after all, on prevention. The IMF also keeps an eye on alternative EWS models developed by the private sector and explores variations on the central IMF model. The private sector models, produced chiefly by investment banks, have shorter time horizons because the aim is to guide short-term investment decisions. Among the IMF's alternative models, one focuses on balance sheet variables, notably for the financial and nonfinancial corporate sectors, and another (estimated with annual data) focuses on fiscal variables.

This comes from a 1999 paper, so the EWS models have evolved. Still, the basic premise behind the EWS remains: forecast currency crisis. So here is what I heard about these models. If you plug the United States into these models you find a major dollar crisis happened years ago. That has not happened though the dollar has already depreciated just over 25% over the last 3 years. Still, there are huge economic imbalances that will require further depreciation of the dollar. A sudden collapse of the Bretton Woods II system could turn this need for further dollar depreciation into a dollar crisis. I hope for a different outcome.

Monday, July 28, 2008

Fannie Mae and Freddie Mac are not essential to the mortgage market; if they were put out of business in an orderly fashion over 5 to 10 years, the market would pick up the business they abandon. Fannie and Freddie exist to provide guarantees for mortgage-backed securities trading in the market. The business is simply insurance.

There are lots of insurance businesses around: property, auto, life and many others. These markets work fine without any government-sponsored enterprises. They are not highly concentrated into a small number of dominant players whose failure would threaten the entire economy; rather, lots of companies compete and spread the risk. Indeed, there are well-established firms in mortgage insurance, but their growth has been stunted by the special advantages Fannie and Freddie enjoy.

[...]

There are more general economic reasons for liquidating Fannie and Freddie, the biggest being that it is very dangerous to maintain such a large role in any market for only two operators. Markets work best when numerous firms compete against each other.

And then there is moral hazard. Knowing they had a federal backstop, Fannie and Freddie held too little capital and the market financed their activities at interest rates very close to those enjoyed by the government. Now we are living through the result. Does it make sense to reconstitute them so that they can engage in a repeat performance?

Sunday, July 27, 2008

In a previous post on the givers and takers among the states, I mentioned that it seemed odd that states in the Rustbelt--those states undergoing significant economic hardships--were on average paying more in federal taxes than they were receiving in federal expenditures over the period 1981-2005. I wanted to be more precise about my observations so I plotted the two figures below showing the relationship between federal dollar expenditures per dollar of federal taxes per state and the economic performance of each state. The first measure comes from The Tax Foundation while the second measure is the year-on-year growth rate of the Philadelphia Fed's coincident indicator series. My thinking--influenced by the optimum currency framework--was that federal fiscal transfers should on balance go more toward those states lagging economically. In short, I expected a negative relationship between the two plotted measures. Here is what I found for the period 1981-2005 (click on figures to enlarge):

The above graph does shows the negative relationship that I expected and it is significant at 6%. However, it has a R-squared of only 0.07--only 7% of variation in federal dollar expenditures per tax dollar can be explained by variation in the states economic performance! I redid the graph for years 2000-2005 and found the following:

Here there is no significant relationship and yet the Rustbelt states are really suffering. So at best, there is a significant relationship that explains next to nothing. My priors did not hold up.

These results were interesting to me because they are important in thinking about whether the United States is truly an optimum currency area (OCA). For the United States to be an OCA--and thus be best served by a single currency and monetary policy--states should either (1) share similar business cycles or (2) have the economic shock absorbers of wage and price flexibility, factor mobility, diversified economies, and federal fiscal transfers. In the former case, similar business cycles among the states mean that a national monetary policy, which targets the aggregate business cycle, will be stabilizing for all states.In the latter case, on the other hand, dissimilar business cycles among the states will result in a national monetary policy that is destabilizing—it will be either too simulative or too tight—for some of the states unless the economic shock absorbers listed above are in place. There is ample evidence that there is significant variation among the states' business cycles. So for the United States to be an OCA it is important for the economic shock absorbers to be in place. The evidence above suggest one of the shock absorbers is missing.

Friday, July 25, 2008

Daniel Drezner that is. He had a short piece on Marketplace that speaks to one of the more frustrating conversations I have on regular basis now. It goes something like this: "It must be nice to have your summers off." or "What exactly do you do during the summer time?" My dear friends who ask this question do not seem to appreciate that a lack of teaching does not mean a lack of work--especially for a tenure track professor! That is why I enjoyed Daniel's piece so much. Listen to it and feel the pain of an academic!

The Wall Street Journal reports on another casualty from that the weakening U.S. economy: state finances. According to the article "states are being slammed by tax shortfalls" and observers "expect it to get worse before it gets better." Amidst this gloomy news--especially for tenure track professors at a state university like me--some states should take solace in the fact that there are federal fiscal transfers from the U.S. government that can serve to offset cyclical economic pressures. Note, though, that I say some states since one state's gain is another state's loss in the form of federal taxes. Where the states fall is tracked by The Tax Foundation in Washington, D.C. They have a series called "deficit neutral federal expenditures per dollar of federal taxes" that I have listed in the figure below (click to enlarge). The numbers for the District of Columbia are striking, but not really surprising. What is surprising is that the heart of the Rustbelt states--Michigan, Indiana, and Ohio--were net givers. Michigan, for example, got 80 cents back for every dollar it paid in federal taxes. One would think those states suffering the most economically would be getting the most federal support.

Wednesday, July 16, 2008

Amidst the headline news of failing financial institutions and stagflationary conditions in the United States, there has been one U.S. story that so far has been good news: central banks in Asia and oil-exporting countries continue to support the financing needs of the United States. According to Brad Sester, this foreign financing was $283.5 billion during the first half of 2008 and continues unabated. As is well known, this support one day will end--the United States cannot forever live beyond its means--but now would not be a good time. Most Americans do not recognize their dependence on this foreign financing nor the added stress the U.S. economy would be under in its absence. The sustained nature of this quiet bailout, as Brad Sester calls it, has been good news for the weakened U.S. economy.

Some observers, however, are now warning this financial lifeline may be in jeopardy given recent events. Ambrose Evans-Pritchard reporting on a Merrill Lynch paper writes the "US faces global funding crisis." From his article:

Merrill Lynch has warned that the United States could face a foreign "financing crisis" within months as the full consequences of the Fannie Mae and Freddie Mac mortgage debacle spread through the world

The country depends on Asian, Russian and Middle Eastern investors to fund much of its $700bn (£350bn) current account deficit, leaving it far more vulnerable to a collapse of confidence than Japan in the early 1990s after the Nikkei bubble burst.

The main point of the Merrill Lynch report is that the recent spate of bad economic news may be the tipping point for the end of this global financing arrangement, popularly known as Bretton Woods II (BWII). Nouriel Roubini makes similar points here. So what do you think? Is this really the end of BWII?

So Fannie Mae and Freddie Mac have fallen and will get a government bailout. Clive Crook has nicely summarized this latest financial domino to fall in the ongoing financial crisis:

US taxpayers are about to find out what their long-standing and (strictly speaking) non-existent guarantee of Fannie Mae and Freddie Mac will cost them. One way to think of it is this: take the US national debt of roughly $9,000bn and add $5,000bn. Not bad for an obligation still officially denied.

Friday, July 11, 2008

This has been the week of dump the dollar peg in the Gulf States. First, it was reported on Sunday that some officials from Abu Dhabi think the United Arab Emirates should replace its dollar peg with one tied to a basket of currencies. At the same time, Nouriel Roubini posted an article comparing the coming collapse of the Bretton Woords II system with that of Bretton Woods I where, among other things, he too called for the end of the dollar peg in the Gulf States. Then on Monday the Financial Times (FT) published its "Dollar-pegged out" editorial. Here the FT similarly argued the Gulf States needs to abandon the dollar peg and move to a basket of currencies that included the price of oil. The FT's editorial, in turn, made Brad Sester happy who followed up on Tuesday with a posting to his blog that furthered the arguments made in the FT. On Wednesday, Jeffrey Frankel, the originator of the currency-basket-including-oil idea chimed in on this debate with this piece. Then on Thursday the Wall Street Journal RTE blog posted the "Dollar Peg Gets Taken Down a Peg." And today, ordinary people like me are sifting through this debate, considering how such a change would take place and what it would mean in the near term.

But first, let's review the thinking behind the calls for the Gulf States to abandon their dollar pegs. Martin Feldstein explains it this way:

The double-digit inflation problem in Saudi Arabia and its Gulf neighbours is different from that of other emerging market economies. Although the rising price of imported food affects them all, the inflation problem in the Gulf region is exacerbated by their fixed exchange rate policy.

The peg to the dollar contributes to Saudi inflation in two ways. First, the dollar link forces the Saudi central bank to match US interest rates. As the Fed lowered its interest rate from 5.25 per cent last summer to 2 per cent now, the Saudis had to cut their interest rate. If they had not done so, investors around the world would have flooded Saudi Arabia with funds seeking the higher yield on a currency that is pegged to the dollar. While cutting rates was a good policy for the US as its economy weakened, it was a terrible policy for Saudi Arabia, which is experiencing an overheated domestic economy with rapidly rising inflation.

The dollar peg also raises Saudi inflation by increasing the cost of imports as the dollar declines relative to the euro, the yen and other currencies. The US is the source for only about 12 per cent of Saudi imports. The 15 per cent decline of the dollar relative to those currencies during the past year meant that the prices paid by the Saudis for the goods that they bought from Europe, Japan and elsewhere rose more than 15 per cent. The large US trade deficit is likely to continue to force the dollar to decline against other main currencies. The result will be a continuing source of imported inflation in Saudi Arabia and other countries that tie their currencies to the dollar.

Inflation in Saudi Arabia and the other Gulf states is depressing real incomes of millions of low-income workers. The combination of the dollar peg and the declining dollar is also reducing the value of the remittances that large numbers of foreign workers send home to their families in low-income countries such as India and Pakistan. Since these foreign workers make up more than half of the total workforce in Saudi Arabia and an even larger share in the less populous states of the region, their discontent is a significant risk to local stability.

Because of their dollar pegs, then, the Gulf States are importing the highly stimulative U.S. monetary policy at the very time their overheating economies need a tighter monetary policy. The remedy, as argued by the above individuals and media outlets, is to change the composition of their peg to a basket of other currencies and oil. Doing so, would mean that their "currencies would appreciate when oil is strong, and depreciate when it is weak" and "make for smoother adjustments than double-digit inflation" (FT).

It is clear that the dollar peg is distortionary for the Gulf States. It is also clear there is an end game in sight: either the Gulf States change their peg or continued inflation will effectively do it for them. The currency-oil basket makes sense to me as a long-term solution, but what about in the short-term when the transition between pegs would take place? What happens if in abandoning their dollar peg the Gulf States make other important dollar peggers like China nervous about capital losses on their own dollar holdings? This could start a run on the dollar and lead to more distress in our battered financial markets. So when I read these calls for dumping the dollar peg, I agree in principle but get concerned as to what would actually happen in practice.

Is there a way to guarantee the transition will be orderly? My currentthinking is that part of the solution lies with the Fed: it should do more to reign in global inflation. This would remove the inflationary pressures in the Gulf States and give them more time to work on a orderly transition. It would also reduce the likelihood of a run on the dollar.

Monday, July 7, 2008

Take a look at this Portfolio.com NCAA tournament-style bracket where you pick who killed the economy. I might have added some brackets for certain mortgage lenders, the debt-addicted American consumer, and those prominent academic economists who gave credence to the Fed's low interest rate policy back in 2003. Still, it is a fun distraction to check out.

In thinking about today's global inflation problem and the role U.S. monetary policy is playing in it, it struck me that we have seen this story before. The collapse of Bretton Woods system--the global monetary system from the end of WWII through the early 1970s-- was due to the United States abusing it role as the anchor currency. During this time, many countries outside the communist block pegged their currencies to the dollar, which was ostensibly backed by gold. Consequently, these countries were willing, initially, to take dollar and dollar-denominated assets for international payments. The United States, however, had pressing domestic spending objectives--the Vietnam War and the Great Society--that required foreign financing. This meant foreign countries took increasingly more dollar and dollar-denominated assets as payment. After some time, these countries began to question whether the U.S. really could back up all of these dollars it was exporting with gold. The answer, of course, was that it could not and eventually the system collapsed. Along with the collapse came a surge in global inflation--the delayed consequence of the U.S. exporting its loose monetary policy to the rest of the world for so many years.

Today, we see the same thing happening. Nouriel Roubini has a post yesterday that makes this very point:

Will the Bretton Wood 2 Regime of fixed and/or heavily managed exchange rates in many emerging market economies collapse in the same way as the Bretton Woods 1 regime (the “dollar standard” regime that ruled after 1945 in the global economy) collapsed in the early 1970s? What are the similarities and differences between those two regimes? It is interesting to note that the same factors – U.S twin deficit, U.S. loose monetary policies and fixed pegs to the U.S. in the dollar standard regime of Bretton Woods (1945-1971) - that led to the commodity inflation and goods inflation in the early 1970s and thus to the demise of the Bretton Woods 1 regime (in the 1971-73 period) are also partially the same factors that are leading now to the rise in commodity and goods inflation in emerging markets that are pegging to the U.S. dollar and/or heavily managing their exchange rates.

Suffice to say history seems to be repeating itself. Maybe this time around the world will become once bitten twice shy about the dollar.

Sunday, July 6, 2008

I see Bryan Caplan is questioning again the necessity of the American Revolution. His views on the American Revolution reminded me of an experience I had in grad school with one of my monetary economics professors.

Somehow, I had picked up J.K. Galbraith's Money: Whence It Came, Where It Went and read his account of how fiat money was used by the Continental Congress to finance the Revolutionary War. The excessive creation and uncertainty surrounding the Continentals, as the fiat currency was known, created an hyperinflation-like environment. Galbraith, unlike Caplan, valued the American Revolution and concluded that "the U.S. rode the wave of hyperinflation into existence." The implication was clear: hyperinflation was needed to win U.S. independence. Feeling all smug about having in hand what seemed to be a hard-to-refute example of high inflation actually being a good thing, I visited my monetary economics professor. Now I am not an advocate for hyperinflation--far from it--but I could not resist the chance to throw a monetary curve ball at my professor. So I did and expected him to strike out. Instead, he hit took my pitch and hit a home run off of it with these sharp words:"David, history is written by the victors!" I left his office humbled once again.

Friday, July 4, 2008

The Economist has an interesting leader on the future of global institutions such as the G8, the IMF, and the UN Security Council. The article, however, makes a glaring omission when it comes to its list of important global institutions. This oversight, though, may be a good thing since there is no point in reminding the world about a highly influential global institution that is largely indifferent to the needs of the world yet highly concerned about the one country that runs it.

So what is this global institution? Let us turn to the Financial Times for the answer:

If there were a Central Bank of the World its monetary policy committee would glance at today’s inflation rates and expectations of future inflation and then raise interest rates. There is no such bank, but there is something close: the US Federal Reserve, the monetary policy of which is mirrored by many countries in the Middle East and Asia. The Fed may not want that responsibility, but it would be wise to worry because, like it or not, low Fed interest rates are contributing to global inflation.

The Fed sets interest rates for Asian [and many Middle Eastern] countries because, explicitly or not, they manage their exchange rates against the dollar. If US interest rates are low, countries targeting the dollar are obliged to follow, because otherwise investors will sell dollars to buy their currency.

So the Fed is a monetary hegemon and its current accommodative stance, while arguably appropriate for the United States, is way too stimulative for the dollar block, those countries whose currencies are tied to the dollar. This is creating some geopolitical angst and is why the Fed should be added to the list of important global institutions.* The global reach of the Fed is something I have discussed before, but recent commentary on this issue by Brad Sester started me thinking more about the fundamental problem with this arrangement. Here is Brad Sester's take on these developments:

The battle lines here are increasingly clear: some argue that the US needs to adjust, by changing its monetary policy to help out countries pegging to the dollar, others argue the rest of the world needs to adjust by letting their currencies appreciate. The US is calling for other countries to have more monetary policy autonomy, and others are calling for the US to, in effect, have a bit less.

...Should the dollar be managed as the world’s currency not the United States’ currency? Does the US derive such large benefits from the dollar’s global role that it should adjust its monetary policy — at a potential cost to the US economy — in order to make it easier for other countries to peg to the dollar?

I would say no. I have long criticized a global monetary and financial system where dollar-reserve growth in the emerging world sustains large US deficits. Over time, the US — and the world — would be better off if Asia and the oil-exporting economies let their currencies float against both the dollar and the euro rather than pegging to the dollar (or managing their currencies against the dollar).

Brad's point is that this arrangement is the one of the main reasons for the global economic imbalances--the large, ongoing U.S. current account deficits and the financing for them from Asia and the Gulf region--and is therefore unsustainable. I agree with Brad's conclusions, but have started thinking about this problem from a different perspective: the dollar bloc an optimum currency area (OCA). Consider the standard criteria of an OCA: similar business cycles, mobile labor, flexible prices/wages, fiscal transfers, diversified economy. The main regions of the dollar block--U.S., Asia, and the Gulf region--fail to meet the OCA criteria on most counts. For example, the U.S. economy is slowing down while the rest of the dollar block is overheating. Or, when was the last time you saw a mass exodus of former Rustbelt workers moving to China or heard of a fiscal transfer from the Gulf region to the Rustbelt? By my reckoning, then, the OCA criteria also indicates the dollar block countries should abandon their pegs and take on more monetary policy autonomy.

With that said, I am fearful of what would happen to the U.S. economy if the dollar block countries abandoned their dollar pegs anytime soon. The Fed's job would certainly be made more challenging and potentially there could be a run on the dollar. In the near term, then, it may be more sensible for the Fed to acknowledge its role as a monetary hegemon and take the lead in fighting global inflation. (Actually, I would have the Fed stabilize global nominal spending, but I digress). This may have some domestic economic consequences, but it would (1) help reign in global inflation and (2) give more time to dollar block to hammer out a coordinated plan of separation.

*According to Ken Rogoff, these countries make up about 60% of the global economy so the Fed's influence is significant.